We provide a
framework to ascertain the required equity risk premium (ERP) within the
setting of Cumulative Prospect Theory (CPT) over arbitrary investment time
periods. Once accounting for behavioral biases in estimating distributions
(generated by using a simulation of asset returns based on a sampling
procedure) and using a CPT utility function, it becomes apparent that the key
determinant of the required ERP is an investor’s time horizon.
Cite this paper
C. Holdsworth and E. Maré, "A Note on a Framework to Assess the Required Equity Risk Premium Using Cumulative Prospect Theory," Theoretical Economics Letters
, Vol. 4 No. 1, 2014, pp. 89-90. doi: 10.4236/tel.2014.41014
 R. Mehra and E. C. Prescott, “The Equity Premium: A Puzzle,” Journal of Monetary Economics, Vol. 15, No. 2 1985, pp. 145-161. http://dx.doi.org/10.1016/0304-3932(85)90061-3
 S. Benartzi and R. H. Thaler, “Myopic Loss Aversion and the Equity Premium Puzzle,” The Quarterly Journal of Economics, Vol. 110, No. 1, 1995, pp. 73-92. http://dx.doi.org/10.2307/2118511
 A. Tversky and D. Kahneman, “Advances in Prospect Theory: Cumulative Representation of Uncertainty,” Journal of Risk and Uncertainty, Vol. 5, No. 4, 1992, pp. 297-323. http://dx.doi.org/10.1007/BF00122574
 D. Kahneman and A. Tversky, “Prospect Theory: An Analysis of Decision under Risk,” Econometrica: Journal of the Econometric Society, Vol. 47, No. 2, 1979, pp. 263-291.
 H. Stott, “Cumulative Prospect Theory’s Functional Menagerie,” Journal of Risk and Uncertainty, Vol. 32, No. 2, 2006, pp. 101-130. http://dx.doi.org/10.1007/s11166-006-8289-6
 A. Booij, B. van Praag and G. van de Kuilen, “A Parametric Analysis of Prospect Theory’s Functionals for the General Population,” Theory and Decision, Vol. 68, No. 1-2, 2009, pp. 115-148. http://dx.doi.org/10.1007/s11238-009-9144-4